What Is Credit Risk Management? Challenges and Best Practices

Introduction

Lending money or extending credit has become an integral part of running a business, but it also entails the inherent risk of borrowers defaulting on their repayment obligations. Enter credit risk management – a crucial safeguard for the stability and profitability of your business.

Despite its significance, credit risk management faces challenges, including the availability of quality data and suitable tools for credit scoring and vetting. To tackle these challenges, implementing best practices becomes imperative. These practices aid in making informed credit decisions, mitigating risks, and nurturing healthy customer relationships.

In this blog, we will explore credit risk management in depth. We’ll discuss the challenges faced by finance professionals and delve into the best practices that can help them effectively manage credit risk. By gaining a deeper understanding of this critical aspect of finance, you can navigate lending operations more confidently and drive sustainable growth.

What is Credit Risk Management?

Credit risk management refers to the process of assessing and mitigating the potential risks associated with lending money or extending credit to individuals or businesses. At its core, it’s about ensuring that borrowers are reliable and will fulfill their repayment obligations.

One of the key aspects of credit risk management is evaluating the creditworthiness of borrowers. This involves a thorough analysis of their financial history, credit score, income stability, and other pertinent factors. By doing so, lenders can gauge a borrower’s ability to repay the loan and make informed lending decisions. 

Credit risk management also involves setting appropriate interest rates and credit limits, as well as monitoring and managing the loan portfolio to identify and address potential risks. Effective credit risk management helps businesses protect themselves against financial losses and ensure the overall stability and profitability of their business.

Challenges in Credit Risk Management

Credit risk management is really important for keeping the financial system stable. But, it’s not easy and there are some major challenges that come with it. These challenges are a big part of financial operations and need to be watched carefully.

In this section, we will talk about the major challenges finance professionals face when they try to manage credit risk.

1. Data quality and accessibility: Data quality plays a crucial role in credit risk evaluation. But most of the time the data available is not very reliable or easy to get. Incomplete or inaccurate data can compromise the decision-making process, necessitating robust strategies to ensure data integrity.
2. Global interconnectedness: When evaluating the credit risk, businesses cannot afford to overlook the global landscape they operate in. The interconnected nature of the global financial system implies that issues in one sector can swiftly reverberate across others. For instance, if a major organization is adversely affected by global factors and defaults on its loans, it can trigger a ripple effect, impacting other businesses connected through lending relationships or financial transactions.
3. Regulatory adherence: The constantly changing regulatory landscape adds complexity to credit risk management. Banks and financial institutions must comply with a multitude of regulations aimed at ensuring stability and transparency in the financial system. Keeping up with these regulations and implementing effective risk management practices can be a daunting task.
4. Rise of non-traditional lenders: The rise of non-traditional lenders and fintech companies presents a challenge for credit risk management. These new players often operate with different risk assessment models and rely on alternative data sources. Incorporating these non-traditional approaches while ensuring accuracy and reliability poses a challenge for risk managers.
5. Economic volatility: Financial landscapes are subject to unpredictable economic fluctuations. The ever-shifting terrain of interest rates, inflation, and market dynamics can substantially impact the creditworthiness of borrowers. Adapting to these changes while safeguarding financial interests is an ongoing challenge.
6. Human factors: The human element introduces its own set of challenges. Misjudgments, communication breakdowns, or ethical lapses can inject unpredictability into credit risk management, underlining the importance of strong internal controls.

6 Effective Business Credit Management Best Practices

Most businesses extend credit without properly assessing the creditworthiness of the customer even though they know it's very risky. If you are wondering why this happens - the answer is very simple - salespersons are often in a hurry to onboard customers faster to achieve their targets. They often pressure the finance teams to extend credit without sufficient due diligence.

Keep in mind that effective credit risk management practices should be tailored to the unique characteristics of each business. This includes identifying customers with a history of frequent payment defaults and crafting a dynamic strategy to mitigate credit risk. With that in mind here are the six most efficient credit risk management best practices you need to know:

1. Provide online credit application forms

Introduce online credit application forms to make customer onboarding smooth and faster. Make all the essential sections mandatory to avoid missing out on any critical information.

An online application makes it easier to gather and store data. Accurate and complete customer information makes your credit risk analysis process more robust. Your credit application must collect the following data:

• Company information
• Bank information
• Commercial trade information
• Provisions in the event of non-payment
• The maximum time required to report a quality/quantity issue
• Terms of payment
• Description of how disputes would be resolved
• Your rights to end credit terms
• Data verification

2. Analyze and predict credit risk

You must consider two factors before you extend credit to your customer. First is the creditworthiness of the customer, and the second is the impact on your cash flow if the customer goes delinquent.

Before customer onboarding, review their payment history from financial institutions and sources such as:

• Credit bureaus like D&B, Experian
• Credit groups like NACM
• Banks
• Public financials (such as income statements, balance sheets, financial ratios, etc.)
• Other sources such as personal guarantees or trade reference

Current and historical data available on these sources help improve your credit scoring accuracy. It also lets you identify the creditworthiness and the potential risk posed by any new customers. This approach helps create a strong functional structure for credit risk management and decision-making.

3. Real-time credit risk monitoring

Credit risk management is a continuous process. In this constantly changing business environment, periodic review of existing customers is essential. Real-time credit risk monitoring keeps you updated about all the risks and opportunities. It helps to identify and mitigate credit risk before it becomes a problem. 

For example, if an existing customer is growing and they have strong financials, you might want to consider increasing their credit limit to expand trade with them. But, if an existing customer makes late payments to other vendors and shows signs of delinquency, you might want to reach out to that customer and collect your payment or modify payment terms at the earliest.

Using automated solutions is an efficient way to monitor risk in real-time. Such solutions integrate easily with credit agencies and send alerts to credit risk management teams directly. These solutions alert you in case of:

• An improvement in credit score
• A decline in credit score
• Bankruptcy
• Recent legal judgments
• Relocation of business
• Change in the management

Source: PYMNTS

4. Establish and follow a credit policy

A credit policy protects your business from financial risks and defaulting customers. A well-defined credit policy allows you to make credit decisions quickly and set payment terms. You must periodically review and update your credit policy to ensure it meets changing market conditions and standards.

To avoid disagreements on credit limits between internal teams, clearly define workflows and the person or team responsible for approving credit limits. To make an effective credit policy, you must clearly document and communicate the following:

• The mission of the credit team
• Goals of the organization
• Roles and responsibilities of team members
• Credit evaluation process 
• Collection process 
• Terms of sale 

5. Use clear communication for payment terms and conditions

Communicating payment terms to customers clearly and on time is crucial to avoid late payments and ensure healthy customer relationships. Here are some extra tips to help you improve customer communications for better credit risk management:

• Establish precise payment terms
• Clarify interest rates and taxes
• Specify due dates and late payment penalties
• Include conditions for closing the credit limit
• Specify clauses for dispute management

6. Leverage automation for fast and accurate credit risk management

Mid-market organizations are increasingly adopting accounts receivable automation solutions to keep pace with their growing clientele and to minimize credit risk. Automation enables real-time credit management, lowers credit risk, and reduces bad debts. Accounts receivable automation supports:

• Accurate credit decision-making
• Automated periodic reviews
• Faster customer onboarding
• Bank and trade reference validation
• Real-time credit risk alerts
• Alert-triggered credit reviews

Souce: PYMNTS

Conclusion

Every business extending credit to customers must adhere to credit risk management best practices to foster business growth and expansion. While your team’s size and expertise are crucial for analyzing and mitigating credit risk, automation solutions can facilitate rapid scalability and enhance process efficiency.

Companies that invest in technology to handle complex credit exposures tend to enjoy better customer relationships and reduced bad debts. If you’re considering an AR automation solution for your business, we can help.

HighRadius offers affordable accounts receivable automation solutions for mid-sized businesses. Our RadiusOne AR Suite streamlines customer onboarding, provides standardized credit assessment, and offers real-time risk monitoring.

Schedule a demo today to explore how RadiusOne can revolutionize your credit risk management efforts and help you effectively mitigate potential risks.